Why Commodity Prices Rise

Rising demand for commodities does not necessarily translate into higher prices.

One of the financial commentators on the news the other night opined that China is still strong so commodity prices will keep rising. He went on to use this as justification for buying resource sector equities.

The poor quality of this advice was mitigated only by the fact that it was free.

The ATC weekly e-mail and the monthly ATC Digest have contained more detailed commentaries on commodity price formation from time to time. See, for example, the July and August 2006 editions of the ATC Digest.

Commodity prices respond to supply shortages or surpluses. When inventories are high, an indicator of supply availability, prices will be low and least volatile. When inventories are low, implying a rising risk of supply shortage, prices will tend higher and be more volatile.

One of the reasons commodity prices rose between 2003 and 2007 was that demand was rising faster than the growth in supply. This caused inventories to decline creating doubts about access to raw materials and providing an incentive for traders to pay more for their supplies.

China certainly played a significant role on the demand side. However, raw material suppliers were also caught napping.

For many years before, investment returns in the resources sector had been poor. Investment markets also had many alternatives to consider. A growing financial services industry and the emergence of internet-based companies were just two sectors that offered more exciting, even if not always better, investment returns.

In Australia, even the previously indomitable spirit of the western Australian mining entrepreneurs was overcome by the attractions of information technology as they swapped industries.

Exploration activity had fallen and production capacity had been limited by a lack of investment capital. As demand first started to accelerate, gun-shy producers were still reluctant to invest. Their first reaction was to use higher cash flows to pay off debt and catch up on some long delayed spending on existing operations.

Sometime later, investment in new capacity became a higher priority. Then they complained that governments had not done enough. Meanwhile, a part of the additional raw material needs was sourced from inventories which progressively fell creating the basis for an eventual cyclical rise in prices.

Just as at the beginning of the last cycle, how high prices rise will depend a great deal on how aware the industry is of its macroeconomic surrounds and the speed of its reaction to changes.

The industry is no longer in the 2002 frame of mind. Who, now, does not know about China emerging as a global economic powerhouse?

While the global credit crisis in 2008 delayed funding for many resource projects, the constraint quickly diminished. New mines are being developed. Supply is rising.

Supplies of base metals, for example, look set to rise by more than 10%, in some cases, over the coming two years. Demand may not grow so strongly despite the growth of China.

Unlike 2002, the supply side is ready to react. The impediments to investment which had delayed a supply response by the industry at the beginning of the last cycle no longer apply. Bear in mind, too, that demand fell or rose little in 2008 and 2009 while supplies rose across many raw material commodity segments. Even where supplies reacted most quickly to the prospect of a recession, as in zinc whose production slipped 3%, consumption dropped 3.3% in 2009.

Supplies are set to bounce back quickly in this cycle in response to higher prices and stronger demand. Even after a year or two of rising demand, markets might still be unable to regain enough tension to cause another cyclical rise in prices.

The speed of industrial output growth in not only China but also the USA, Europe and Japan in the year ahead will be important. But demand will be only one blade of the scissors, with more than the usual amount of uncertainty about this, in any event. The supply side needs to be given as much weight in any conclusion about likely price movements.

There are many uncertainties but one thing is clear: it is simply wrong to think of commodity prices rising in lock-step with greater usage.

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